Tax Type
Corporation Income Tax
Description
Arm's length - intercompany transactions
Topic
Appropriateness of Audit Methodology
Assessment
Date Issued
06-28-2005
June 28, 2005
Re: § 58.1-1821 Application: Corporate Income Tax
Dear ***************************:
This will reply to your letter in which you seek correction of the corporation income tax assessments issued to ***** (the "Taxpayer") for taxable years ended September 30, 1989 through 1993. I apologize for the delay in responding to your letter.
FACTS
The Taxpayer is incorporated and located in ***** ("State A"). In 1991, ***** ("IHC"), a wholly owned subsidiary of the Taxpayer, was incorporated in ***** ("State B") for the purpose of holding the Taxpayer's intangible property. The Taxpayer then transferred its trademarks, tradenames, patents, and other intangibles to IHC in exchange for stock pursuant to Internal Revenue Code ("IRC") § 351. The Taxpayer paid royalties to IHC for the use of the trademarks and tradenames during the taxable years at issue.
The Department's auditor determined that the arrangement between the Taxpayer and IHC improperly reflected the business performed in Virginia because IHC lacked economic substance. As a result, the taxable incomes of the Taxpayer and IHC were consolidated and an assessment was issued for additional tax and interest.
The Taxpayer appeals the assessment on the basis that, although IHC had no employees or physical place of business, it had economic substance because it compensated the Taxpayer for performing its work. The Taxpayer also contends that the intercompany transactions were at arm's length.
In connection with its review of the Taxpayer's appeal, the Department requested information and documentation from the Taxpayer in order to analyze fully the facts surrounding the audit issues. The Taxpayer did not provide any of the requested information or documentation.
DETERMINATION
Although Virginia utilizes federal taxable income as the starting point in computing Virginia taxable income and generally respects the corporate structure of taxpayers, Va. Code § 58.1-446 provides, in pertinent part:
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- When any corporation liable to taxation under this chapter by agreement or otherwise conducts the business of such corporation in such manner as either directly or indirectly to benefit the members or stockholders of the corporation . . . by either buying or selling its products or the goods or commodities in which it deals at more or less than a fair price which might be obtained therefor, or when such a corporation . . . acquires and disposes of the products, goods or commodities of another corporation in such manner as to create a loss or improper taxable income, and such other corporation . . . is controlled by the corporation liable to taxation under this chapter, the Department . . . may for the purpose determine the amount which shall be deemed to be the Virginia taxable income of the business of such corporation for the taxable year.
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- In case it appears to the Department that any arrangements exist in such a manner as improperly to reflect the business done or the Virginia taxable income earned from business done in this Commonwealth, the Department may, in such manner as it may determine, equitably adjust the tax. (Emphasis added.)
The Virginia Supreme Court's opinion in Commonwealth v. General Electric Company, 236 Va. 54 (1988) upheld the Department's authority to adjust equitably the tax of a corporation pursuant to Va. Code § 58.1-446 (or its predecessor) where two commonly owned corporations structure an arrangement in such a manner as to reflect improperly, inaccurately, or incorrectly the business done in Virginia or the Virginia taxable income. Generally, the Department will exercise its authority if it finds that a transaction, or a party to a transaction, lacks economic substance or transactions between the parties are not at arm's length.
You contend that the transactions between the Taxpayer and IHC are at arm's length and do not distort income from business done in Virginia. You also contend that IHC has economic substance because, even though it has no employees or place of business, it pays arm's length fees to the Taxpayer to perform its services.
The only evidence provided by the Taxpayer is a copy of an appraisal performed by an independent third party. The Department does not look solely to the royalty rate when examining the type of transaction at issue. In this case, the Taxpayer transferred assets to a newly created subsidiary in exchange for stock, in a tax-free transaction. If the Taxpayer were dealing with an unrelated third party, it would not transfer assets without consideration, and then agree to pay a royalty for the use of these same assets. Had the assets been transferred to an unrelated third party for their fair market value, the gain realized by the Taxpayer would have been subject to tax by Virginia. Because IHC is wholly owned by the Taxpayer, the Taxpayer never lost the ability to control the subject assets, the rate or terms of the royalty agreement, or the unrestricted use of the assets. The Taxpayer is essentially free to undo the transaction with IHC at any time.
The Taxpayer provided no other evidence at the time of its appeal to support its assertion that the Department's adjustments are invalid. The Department requested that the Taxpayer provide information to substantiate its assertions that IHC had economic substance and that the Taxpayer's intercompany transactions with IHC were at arm's length. The Department has the authority to investigate any books and records of a taxpayer in order to ascertain the proper tax liability. See Va. Code § 58.1-219. Further, Va. Code § 58.1-205 provides that in any proceeding relating to the interpretation of the tax laws of Virginia, an "assessment of a tax by the Department shall be deemed prima facie correct." As such, the burden of proof is on the Taxpayer to show that the transactions with IHC did not improperly reflect the Virginia taxable income of the Taxpayer. Inasmuch as the Taxpayer has not provided the requested information, there is no basis to revise the auditor's adjustments consolidating the income of IHC with the Taxpayer.
Based on the foregoing, the Department's assessments of tax and interest issued to the Taxpayer for the taxable years ended September 30, 1989 through 1993 are upheld. The Taxpayer should remit its payment for the tax and updated interest as shown on the enclosed schedule to: Virginia Department of Taxation, 3600 West Broad Street, Suite 160, Richmond, Virginia 23230, Attention: *****. Payment must be received within 30 days from the date of this letter to avoid the accrual of additional interest. If you have any questions regarding payment of the assessments, you may contact ***** at *****.
The Code of Virginia sections cited, along with other reference documents, are available on-line in the Tax Policy Library section of the Department's web site, located at www.policylibrary.tax.virginia.gov. If you have any questions regarding this determination, you may contact ***** in the Office of Policy and Administration, Appeals and Rulings, at *****.
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- Sincerely,
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- Kenneth W. Thorson
Tax Commissioner
- Kenneth W. Thorson
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AR/13899B
Rulings of the Tax Commissioner